Optimal Monitoring Schedule in Dynamic Contracts.

Monitoring in Dynamic Contract Design Adverse events are harmful to a firm or to the society. In many occasions, better effort in safeguarding a system can reduce the chance of such events. Consider the scenario in which a company (i.e., "principal") hires a subcontractor (i.e., "agent") to fulfill the duty of a safeguard. The agent's effort is unobservable, and the principal may, from time to time, conduct on-site monitoring. However, monitoring is often costly to the principal. In a dynamic environment in which the principal can use both monetary payments and monitoring to induce effort, how to optimally schedule them is a challenging and important problem. In "Optimal Monitoring Schedule in Dynamic Contracts," M. Chen, P. Sun, and Y. Xiao provide theoretical guidance on designing the optimal monitoring and payment schedules that always induce full effort from an agent. They formulate the contract design problem as a stochastic optimal control model and provide a complete characterization of the optimal solution. Their analysis suggests that the optimal dynamic contracts are simple to describe, easy to compute and implement, and intuitive to explain. Consider a setting in which a principal induces effort from an agent to reduce the arrival rate of a Poisson process of adverse events. The effort is costly to the agent and unobservable to the principal unless the principal is monitoring the agent. Monitoring ensures effort but is costly to the principal. The optimal contract involves monetary payments and monitoring sessions that depend on past arrival times. We formulate the problem as a stochastic optimal control model and solve the problem analytically. The optimal schedules of payment and monitoring demonstrate different structures depending on model parameters. Overall, the optimal dynamic contracts are simple to describe, easy to compute and implement, and intuitive to explain. [ABSTRACT FROM AUTHOR]